The Xerox Corporation Fraud Case (2002)

06C275 06C277

By Vrij Ghose Neha Bhargava

Xerox Corporation is a global document management company which manufactures and sells a range of color and black-and-white printers, multifunction systems, photo copiers, digital production printing presses, and related consulting services and supplies. Xerox is headquartered in Norwalk, Connecticut, though its largest population of employees is based in and around ochester, New !ork, the area in which the company was founded.

History
"he Xerox #$% was the first one-piece plain paper photocopier, and sold in the thousands. Xerox was founded in $#&' in ochester, New !ork as ("he )aloid Company(, which originally manufactured photographic paper and equipment. "he company subsequently changed its name to ()aloid Xerox( in $#*+ and then simply (Xerox(

in $#'$. "he company came to prominence in $#*# with the introduction of the first plain paper photocopier using the process of xerography ,electrophotographydeveloped by Chester Carlson, the Xerox #$%. "he #$% was so popular that by the end of $#'$, Xerox had almost .'& million in revenue. /y $#'*, revenues leaped to over .*&& million. /efore releasing the #$%, Xerox had also introduced the first xerographic printer, the (Copyflo( in $#**. "he company expanded substantially throughout the $#'&s, making millionaires of some long-suffering investors who had nursed the company through the slow research and development phase of the product. 0n $#'&, the (1ilson Center for esearch and "echnology( was opened in 1ebster, New !ork, a research facility for

xerography. 0n $#'$, the company changed its name to (Xerox Corporation(. Xerox common stock ,X X- was listed on the New !ork 2tock 3xchange in $#'$ and on the Chicago 2tock 3xchange in $##&. 0n $#'4, Xerox introduced the Xerox +$4, the first desktop plain-paper copier, bringing Carlson5s vision of a copier that could fit on anyone5s office desk into a reality. "en years later in $#64, a color copier followed. "he laser printer was invented in $#'# by Xerox researcher 7ary 2tarkweather by modifying a Xerox copier. "his development resulted in the first commercially available laser printer, the Xerox #6&&, being launched in $#66. 8aser printing eventually became a multi billion dollar business for Xerox. 0n $#6&, under company president Charles 9eter :cColough, Xerox opened the Xerox 9; C ,Xerox 9alo ;lto esearch Center- research facility. "he facility developed many modern computing technologies such as the mouse and the graphical user interface ,7<0-. =rom these inventions, Xerox 9; C created the Xerox ;lto in $#64, a small minicomputer similar to a modern workstation or personal computer. "his machine can be considered the first true personal computer, given its versatile combination of a cathode-ray-type screen, mouse-type pointing device, and a >13 "!-type alphanumeric keyboard. /ut the ;lto was never commercially sold, as Xerox itself could not see the sales potential of it. 0n $#6#, several ;pple Computer employees, including 2teve ?obs, visited Xerox 9; C, interested in seeing their developments. ?obs and the others saw the commercial potential of the 7<0 and mouse, and began development of the ;pple 8isa, which ;pple introduced in $#+4.

The Xerox Alto workstation was developed at Xerox PARC

0n the mid $#+&s, ;pple considered buying Xerox@ however, a deal was never reached. ;pple instead bought rights to the ;lto 7<0 and adapted it into to a more affordable personal computer, aimed towards the business and education markets. "he ;pple :acintosh was released in $#+%, and was the first personal computer to populariAe the 7<0 and mouse amongst the public. "he company was revived in the $#+&s and $##&s, through improvement in quality design and realignment of its product line. Xerox worked to turn its product into a service, providing a complete (document service( to companies including supply, maintenance, configuration, and user support. "o reinforce this image, the company introduced a corporate signature, ("he Bocument Company( above its main logo and introduced a red (digital X(. "he (digital X( symboliAed the transition of documents between the paper and digital worlds. ;lthough Xerox is a global brand, it maintains a Coint venture, =uCi Xerox, with ?apanese photographic firm =uCi 9hoto =ilm Co. to develop, produce and sell in the ;sia-9acific region. =uCi 9hoto =ilm Co. is currently the maCority stakeholder, with 6*D of the shareholding. Xerox 0ndia, formerly :odi Xerox, is Xerox5s 0ndian subsidiary derived from a Coint venture formed between Br. /hupendra Eumar :odi and ank Xerox in $#+4. Xerox obtained a maCority stake in $### and aims to buy out the remaining shareholders. Xerox now sponsors the =actory Bucati "eam in the 1orld 2uperbike Championship, under the name of the (Xerox Bucati(.

Its Current array of products

Xerox today manufactures and sells a wide variety of office and production equipment including 8CB :onitors, photo copiers, Xerox 9haser printers, multifunction printers, large-volume digital printers as well as workflow software under the brand strategy of =ree=low. Xerox also sells scanners and digital presses. Fn G# :ay G&&+, xerox launched X3 FX i7en % digital press. 0t also produces fax machines, professional printers, black and white copiers, and several other products.0n addition, Xerox produces many printing and office supplies

Xerox logo $#6$HG&&+ designed by Chermayeff I 7eismar. ;lthough Xerox is a global brand, it maintains a Coint venture, =uCi Xerox, with ?apanese photographic firm =uCi 9hoto =ilm Co. to develop, produce and sell in the ;sia-9acific region. =uCi 9hoto =ilm Co. is currently the maCority stakeholder, with 6*D of the shareholding. Xerox 0ndia, formerly :odi Xerox, is Xerox5s 0ndian subsidiary derived from a Coint venture formed between Br. /hupendra Eumar :odi and ank Xerox in $#+4. Xerox obtained a maCority stake in $### and aims to buy out the remaining shareholders.J$&K Xerox now sponsors the =actory Bucati "eam in the 1orld 2uperbike Championship, under the name of the (Xerox Bucati(.

The Xerox trademark

"he word (xerox( is commonly used as a synonym for (photocopy( ,both as a noun and a verb- in many areas@ for example,"I xeroxed the document and placed it on your desk." or "Please make a xeroxed copy of the articles and hand them out a week efore the exam". " hough both are common, the company does not condone such uses of its trademark, and is particularly concerned about the ongoing use of Xerox as a verb as this places the trademark in danger of being declared a generic word by the courts. "he

company is engaged in an ongoing advertising and media campaign to convince the public that Xerox should not be used as a verb.J$+KJ$#K "o this end, the company has written to publications that have used Xerox as a verb, and has also purchased print advertisements declaring that (you cannot 5xerox5 a document, but you can copy it on a Xerox /rand copying machine(. Xerox Corporation continues to protect its trademark diligently in most if not all trademark categories. Bespite their efforts, many dictionaries continue to mention the use of (xerox( as a verb, including the Fxford 3nglish Bictionary. 0n 0ndia, 9arle ;gro5s (Eaccha :ango /ite( candy ran a tagline claiming (Eacche ;am Ea Xerox( which means (Xerox of the raw mango(. "he tag was later modiified to (Eacche ;am Ea Copy(, which means (Copy of the aw :ango.( 0n G&&+, Xerox changed its logo to a red sphere with a white X with three grey stripes. "he change is meant to reflect less on the photo copying duties Xerox has carried out and instead to refocus on document management and solutions across the world for companies

Fact File..
Xerox Corporation Type Founded 9ublic ,N!23L X Xochester, New !ork, <2; ,$#&'Norwalk, Connecticut, <2; Fffices in ochester, New !ork

Headquarters

Fortune 500

anked $%*th

Industry

Bocument 2ervices Computer 9eripherals

Products

Bigital 0maging 9rinters M.$6.G billion <2B ,G&&6www.xerox.com

Market cap .#.+* billion ,G&&+-J$K Revenue !e"site Emp oyees *6,%&& ,G&&6-

The Founders
"he E9:7 network was formed in $#+6 when 9eat :arwick 0nternational and Elynveld :ain 7oerdeler merged along with their respective member firms. "here were four key figures in the formation of E9:7. "hey are the founding members of the present organiAation. !lynveld 9iet Elynveld founded the accounting firm Elynveld Eraayenhof I Co in ;msterdam in $#$6. Peat 1illiam /arclay 9eat founded the accounting firm 9eat I Co in 8ondon. "arwick ?ames :arwick established the accounting firm :arwick, :itchell I Co in New !ork City in $+#6. #oerdeler Br. einhard 7oerdeler was the first president of the 0nternational =ederation of ;ccountants and a chairman of E9:7. )e is credited with laying the foundations of the Elynveld :ain 7oerdeler merger

About them
E9:7 firms are some of the worldNs leading providers of audit, tax and advisory services. "hey have $4*,&&& people operating in over $%& countries. E9:7 was established in 0ndia in 2eptember $##4, and has rapidly built a significant competitive presence in the country. "he firm operates from its offices in :umbai, 9une, Belhi, Eolkata, Chennai, /angalore and )yderabad, and offers its clients a full range of services, including financial and business advisory, tax and regulatory, and risk advisory services. 0n 0ndia, E9:7 has a client base of over G&&& companies. "he firm5s global approach to service delivery help provide value-added services to clients. "he firm serves leading information technology companies and has a strong presence in the financial services sector in 0ndia while serving a number of market leaders in other industry segments. "heir practice is organiAed around our ;udit, "ax and ;dvisory practices.

Fact File

Type Founded

2wiss Cooperative $#+6@ merger of 9eat :arwick 0nternational and Elynveld :ain 7oerdeler

Headquarters New !ork, N! ,global"im =lynn ,Chairman and C3F?ohn /. )arrison, Chairman E9:7 ;sia 9acific #ey peop e egion /en van der Oeer, Chairman E9:7 3urope, :iddle 3ast and ;frica egion Industry $ervices Revenue 9rofessional services ;udit "ax ;dvisory M.GG.6 billion <2B ,G&&+-

Emp oyees $4',+#'P

!e"site

www.kpmg.com

The KPMG Xerox Fraud Case

0n one of the latest scandals involving a prominent ;merican corporation, Xerox revealed in G&&G that over the five years prior to G&&G it had improperly classified over .' billion in revenue, leading to an overstatement of earnings by nearly .G billion. "he announcement of Xerox is not entirely new. "he 2ecurities and 3xchange Commission ,23C- began an investigation that ended in ;pril of that year. "he 23C had charged the producer of copiers and related services with accounting manipulations. 0t was estimated at the time, however, that the amount involved was about half that which is now stated, or about .4 billion. ; settlement was eventually reached that included a .$& million fine, as well as an agreement to conduct a further audit. 0t was this audit that produced the .' billion figure.

There were two basic manipulations that formed the basis for the SEC investigation.
"he first was the so-called Qcookie CarR method. "his involved improperly storing revenue off the balance sheet and then releasing the stored funds at strategic times in order to boost lagging earnings for a particular quarter. "his is a widely used manipulation.. "he second methodSand what accounted for the larger part of the fraudulent earningsSwas the acceleration of revenue from short-term equipment rentals, which were improperly classified as long-term leases. "he difference was significant because according to the 7enerally ;ccepted ;ccounting 9rinciples ,7;;9-Sthe standards by which a companyNs books are supposed to be measuredSthe entire value of a long-term lease can be included as revenue in the first year of the agreement. "he value of a rental, on the other hand, is spread out over the duration of the contract. "he effect of the manipulation was that Xerox could count as earnings what was essentially future revenue. "his boosted short-term profits and allowed the company to meet profit expectations in $##6, $##+ and $###, though it had the effect of

reducing earnings during the past two years. 0n $##+ Xerox reported a pretax income of .*6# million, while it should have reported a loss of .$4 million. Fn the other hand, the .$46 million loss for G&&$ will become a .4'* million gain after the manipulation is reversed. "he .$.# billion total that will now be subtracted from revenue reported from $##6-G&&$ will be added to future reports. "hus, unlike some of the other scandals that have emerged over the past several months, Xerox has not been accused of falsely creating unearned income. ather it spread its income out in a fraudulent manner. "o the same end, 1orldCom improperly capitaliAed about .% billion in ordinary expenses in order to allow the company to deduct the expense over a period of decades rather than writing it off all at once. /oth these methods serve to boost short-term profits.

$hy carry out these manipulations when the extra money earned in one year would have to e su tracted from future years%

"his was necessary because corporations are under enormous pressure from 1all 2treet investors to keep up short-term earnings. Ftherwise, their share values will drop, which not only threatens companies heavily reliant on share values to finance debt, but also has financial consequences for top executives, whose astronomical incomes are bound up with stock options. "he 23C investigation noted that Qcompensation of Xerox senior management depended significantly on their ability to meet JearningsK targets.R /ecause of the accounting manipulations, top Xerox executives were able to cash in on stock options valued at an estimated .4* million. Xerox stock rose to a peak of .'& a share in mid-$###, when the company was carrying out the accounting fraud. 0t has since declined sharply and is now trading at about .6.

Confronted with declining revenue during the late $##&s that should have led to lower than expected earnings reportsSthereby reflecting the true nature of the companyNs deepening problemsSXerox decided to cook the books. "his was done quite methodically. 0nternal documents have recorded discussions among top officials at Xerox concerning ways to manipulate accounting to allow the company to meet 1all 2treet expectations. 3xecutives apparently calculated the exact amount that would have to be altered in order to allow the company to Cust meet or slightly exceed Qfirst call consensusR expectations on 1all 2treet, which are determined prior to a companyNs release of earnings data. 0n $##6, for example, expected earnings were at .$.## a share, while reported earnings were .G.&G. ;ctual earnings, correcting for the accounting manipulations, were at .$.'*. <sing its earlier underestimate of .4 billion in improperly classified revenue, the 23C calculated these actual earnings. 0n $##+, expected and reported earnings were both at .G.44 while actual earnings were only .$.6G a share. 0n $###, reported earnings beat expected earnings by one cent, while actual earnings fell short by almost *& cents. "his is a striking example of a company fitting earnings to expectations in order to prevent a run on stock. 0t is, however, a fairly common practice. :any companies, like 7eneral 3lectric for example, always seem to come out Cust barely ahead of expectations. 0ndeed, recent studies have found the distribution of reported earnings of maCor companies around expectations was skewed to the positive side. "hat is, it is more likely for a company to beat than to fall short of expectations, suggesting that there are many companies that have been following the same accounting practices as Xerox. 8ike the 1orldCom fraud, XeroxNs manipulation should have been easy to detect if there was anyone interested in looking. ;s former 23C chief accountant 8ynn "urner noted, Q"hese numbers have gotten so large that itNs taking to auditors driving past :t. 3verest and saying they never saw it.... Corporate ;merica has somehow gotten into the mindset that this is FE.R XeroxNs auditor during the period in question was E9:7, one of the Qbig fourR accounting firms that dominate the profession. E9:7 was fired in Fctober and replaced by 9ricewaterhouseCoopers. E9:7 was also part of the 23C investigation that began last year. "he evidence suggests that the auditing firm knew what was going on and decided to allow it to continue. ;n internal document obtained by the 23C contained a statement by a E9:7 official acknowledging that XeroxNs schemes constituted Qhalf-baked revenue recognition.R 1hen the E9:7 auditor in charge of the Xerox account began to raise some concerns about the companyNs improper techniques, %e &as rep aced &it% someone e se'

3arlier this year, the 23C considered filing civil charges against top executives at both E9:7 and Xerox. "he accounting firm is currently facing lawsuits from shareholders charging the company with failing to audit Xerox properly. E9:7 is also under scrutiny for its role in approving the books of the drug store chain ite ;id, which recently acknowledged that it inflated its income by more than .$ billion over a two-year period. 0t also approved the books of the collapsed /elgian software company 8ernout I )auspie 2peech 9roducts NO, which has admitted to fabricating 6& percent of sales at its largest unit. "he Xerox case has focused attention on the role of the 23C and its chairman, )arvey 9itt. 9itt, a former lawyer for the big accounting firms including E9:7, met with E9:7Ns new chairman, 7ene FNEelly, in ;pril. FNEelly issued a statement declaring he told 9itt at this meeting that any 23C action against E9:7 would be QunfoundedR and Qwould pose serious disruption ... in the capital markets.R 9itt denied that the two discussed Xerox at all during the meeting. 2uch a discussion, if it took place, would be a serious violation of norms of independence. "he 23C, having failed to raise any flags while the fraud was being carried out, appears complicit in the scandal. /ecause of its protracted crisis, Xerox has been forced to sell off some of its assets. 0t managed to renegotiate its credit earlier this month, but at higher interest rates. 0f the company had failed to renegotiate its credit line, it may have been unable to meet its obligations, forcing it into bankruptcy. "his almost happened once before, in late G&&&. 0n an attempt to cut back on costs, Xerox has laid off thousands of workers in the past two years and may well make further retrenchments in the future. Fn the other hand, as XeroxNs troubles grew more severe, the companyNs C3F ;nne :ulchay received a pay package in G&&$ that could be worth as much as .G* million.

According to SECs complaint, the accounting violations committed by Xerox are

 Accelerating leasing revenue Xerox allegedly repeatedly changed the way it accounted for lease revenue but failed to disclose that the associated gains were the result of accounting changes rather than improved operating performance. Moreover, many of the practices used failed to comply with GAAP. For example, Xerox used a return on e uity allocation method that involved calculating the estimated fair value of the e uipment as the portion of the lease payments remaining after subtracting the estimated fair value of the services and financing components. As the estimated fair value of services and financing declined, the e uipment sales revenue that was recogni!ed immediately increased. Xerox was also accused of accelerating the recognition of revenues by immediately recogni!ing as the revenue price increases and extensions of existing lease rather than recogni!ing the increases over the remaining life of the lease.

Improper increases in residual values of leased equipment

Xerox allegedly ad"usted the estimated residual value of leased e uipment #that is, its remaining value at the end of the lease term$ after the inception of the lease in violation of GAAP. %&' alleges that this write(up in the residual value of e uipment was used to credit the cost of sales, were recorded close to the end of uarterly reporting periods as )a gap(closing measure to help Xerox meet or exceed internal and external earnings and revenue expectations.* Acceleration of revenues from portfolio asset strategy transactions %elling investors the revenue streams from portfolios of its leases that otherwise would not have allowed for immediate revenue recognition. %&' alleges that Xerox used these transactions to recogni!e revenue that would have otherwise been recogni!ed in future periods and failed to disclose this practice.

Fraudulent manipulation of reserves and other income Xerox allegedly increased its earnings by releasing excess reserves that were originally established for some other purpose into income in violation of GAAP. Xerox also allegedly systematically released a gain associated with the successful resolution of a dispute with the +nternal ,evenue %ervice to improperly increase earnings from -../ through 0111. Although GAAP re uired that the entire gain be recogni!ed upon the completion of all legal contingencies in -..2 and -..3, Xerox used most of it to meet its earnings targets. Failure to disclose factoring transactions Xerox allegedly failed to disclose factoring transactions that allowed it to report a positive year end cash balance, instead of a negative one. 4his factoring involved Xerox selling its receivables at a discount in order to reali!e instant cash instead of a future stream of cash. According to %&' complaint, analysts loo5ed to Xerox to increase its li uidity and called for stronger end(of year cash balances in -.... 6nable to generate cash, Xerox management instructed its largest operating units to explore the possibility of engaging in factoring transactions with local ban5s. 4hese transactions materially affected Xerox7s -... operating cash flows but these transactions were not disclosed in its -... financial statements. +n some of the factoring transactions involved buy(bac5 agreements in which Xerox would reac uire the receivables after the end of the year. 8y accounting for these

transactions as true sales, Xerox violated GAAP. 9ot only did Xerox fail to disclose the agreements, it failed to reverse them in the next year.

:ithout admitting or denying the allegations of the complaint, Xerox consented to a final "udgment that includes a permanent in"unction from violating the antifraud, reporting and record5eeping provisions of the federal securities laws, specifically %ection -/#a$ of the %ecurities Act of -.;; and %ections -1#b$, -;#a$, -;#b$#0$#A$ and -;#b$#0$#8$ of the &xchange Act and ,ules -1b(2, -;a(-. -;a(-;, -0b(01 and -;b0(- promulgated there under. +n addition, Xerox agreed to restate its financials for the years -../ through 0111 and pay a <-1 million civil penalty. As part of this agreement, Xerox also agreed to have its board of directors review the company7s material internal accounting controls and policies.

Burning a holeThe Consequences that followed

Xerox Corp. agreed to pay .'6& million while E9:7 889 had to pay .+& million, to settle an eight-year-old securities lawsuit filed on behalf of Xerox investors who claimed Xerox committed accounting fraud to meet 1all 2treet earnings expectations. "he case of Carlson v. Xerox Corp., filed on behalf of purchasers of Xerox common stock and bonds from between =ebruary $##+ and ?une G6, was something of a high profile one for the pre-3nron era. 0n ;pril G&&G, Xerox had already agreed to a .$& million fine as part of a settlement with the 2ecurities and 3xchange Commission. "he fine was the largest ever paid by a company to settle with the 23C at that time. "he 23C charged that the copier company schemed to defraud investors during a four-year period by using what it called (accounting actions( and (accounting

opportunities( to meet or exceed 1all 2treet expectations and disguise its true operating performance. "he commission stated at the time that most of the actions violated generally accepted accounting principles, and thus accelerated the company5s recognition of equipment revenue by more than .4 billion and increasing its pretax earnings by approximately .$.* billion. 0n G&&*, E9:7 agreed to pay .GG.* million to settle 23C charges related to its audits of Xerox from $##6 through G&&&. <nder that arrangement, the firm agreed to relinquish the .#.+ million in fees it received for auditing Xerox5s books during that time, and pay .G.6 million in interest and a .$& million civil penalty. "he total package was the largest payment ever made to the 23C by an audit firm. "he 2ecurities and 3xchange Commission also charged six former senior executives of Xerox Corporation, including its former chief executive officers, 9aul ;. ;llaire and 7. ichard "homan, and its former chief financial officer, /arry B. omeril, with securities fraud and aiding and abetting Xerox5s violations of the reporting, books and records and internal control provisions of the federal securities laws. "he six defendants agreed to pay over .GG million in penalties, disgorgement and interest without admitting or denying the 23C5s allegations. "he 23C intended to have these funds paid into a court account pursuant to the =air =und provisions of 2ection 4&+,a- of the 2arbanes-Fxley ;ct of G&&G for ultimate distribution to victims of the alleged fraud. "he defendants had each offered to settle by consenting, without admitting or denying the 23C5s allegations, to the entry of a final Cudgment in the civil action thatL

permanently enCoins each of them from violating 2ection $&,b- of the 3xchange ;ct and ule $&b-* there under, aiding and abetting violations of 2ections $4,a-, $4,b-,G-,;- and $4,b-,G-,/- of the 3xchange ;ct and ules $Gb-G&, $4a-$ and $4a-$4 there under, and ,except for ;llaire and "homanviolating 2ection $4,b-,*- of the 3xchange ;ct and ule $4bG-$ there under@ imposes an officer and director bar against ;llaire ,* years-, "homan ,4 yearsomeril ,permanent-, and =ishbach ,* years-@

requires each of them to pay civil penalties in the following amountsL .$ million for ;llaire@ .6*&,&&& for "homan@ .$ million for omeril@ .$&&,&&& for =ishbach@ .6*,&&& for :archibroda@ and .6*,&&& for "ayler@ requires =ishbach and :archibroda to relinquish their respective rights to certain deferred bonuses ,.$G6,&4* for =ishbach and .*&,GG+ for :archibroda- plus accrued interest on these amounts.

requires each of them to pay disgorgement and preCudgment interest thereon in the following amountsL

;llaireL "homanL omerilL =ishbachL

.*,'#','6+ - disgorgement@ .$,#4+,$G% - preCudgment interest@ .%,''+,4#' - disgorgement@ .$,%%&,##4 - preCudgment interest@ .G,#+6,G+G - disgorgement@ .$,GG6,'++ - preCudgment interest@ .''',6%+ - disgorgement@ .G+#,#&% - preCudgment interest@

:archibrodaL .G64,4## - disgorgement@ .++,#G& - preCudgment interest@ "aylerL

.#G,'&4 - disgorgement@

.4G,4#6 - preCudgment interest@ and@

equired =ishbach and :archibroda to relinquish their respective rights to certain deferred bonuses ,.$G6,&4* for =ishbach and .*&,GG+ for :archibroda- plus accrued interest on these amounts.

0n addition, both omeril and "ayler agreed to the entry by the 23C of an Frder pursuant to ule $&G,e- of the 23C5s ules of 9ractice that suspends each of them ,based on the entry of the inCunction in the federal court action- from appearing or practicing before the 23C as an accountant. "his Frder will suspend omeril permanently and suspend "ayler for three years with a right to apply for reinstatement after the three-year period.